An annuity is a contract issued by an insurance company and has two phases: an accumulation phase, during which the contract builds a cash value and money is added, and a payout phase, during which the funds are distributed. Variable annuities typically offer single or flexible premiums, a broad range of subaccounts, tax deferral on earnings, and, more recently, death and living benefits. Values change according to the performance of the subaccounts, which typically are invested in mutual funds.
A popular feature of variable annuity (“VA”) contracts is a Guaranteed Minimum Withdrawal Benefit (GMWB). The purpose of the GMWB is to provide a guaranteed level of income to the policy holder. The policy holder has the right to withdraw a specified percentage (e.g., seven percent) of an initial deposit every year until the entire principal is returned. For example, assume an investor invests $100,000 in a contract with a GMWB feature. The $100,000 is placed in an investment account that invests in mutual funds. Assuming a seven percent withdrawal allowance, the policy holder could withdraw $7,000 each year until the total withdrawn reaches $100,000. This would take just over 14 years. Note the policy holder can withdraw the funds irrespective of how the investment account performs. The policy holder's income stream is protected, regardless of market performance. If the market performs poorly, the policy holder receives the guaranteed annual withdrawal of $7,000. At the end of the 14 years, the policy holder's guarantee would be exhausted and the policy would continue as a non-GMWB VA policy.
The reporting and risk management of this feature provides some interesting challenges. SFAS 133 is a statement issued by the Financial Accounting Standards Board (“FASB”), which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Under SFAS 133, a GMWB is classified as a derivative, and should be marked to market under the same methodology as other equity options.
Various strategies are being employed to risk manage GMWB blocks: (a) Delta Hedging with Equity and Bond Futures—not very effective since a GMWB's exposure to “vega” (implied volatility) is not hedge-able with futures, and substantial EPS (earnings per share) and economic risks remain; (b) Delta Hedging and Equity Vanilla Options—reasonably effective to hedge economic and EPS exposure over intermediate term and stable markets, but long term effectiveness is unlikely due to cost and exposure to second and third order risks; and (c) Delta Hedging and Exotic Equity Options—less expensive and reasonably effective to hedge accounting and EPS exposure over intermediate term and stable markets, but long term effectiveness is not well understood.
Another common feature of VA contracts is the Guaranteed Minimum Death Benefit (“GMDB”), which typically guarantees that a certain amount will be paid to a beneficiary in the event that the policy holder dies. If the policy holder dies at a time when the aggregate value of the subaccounts is less than the guaranteed value, the insurance company pays out the amount of any shortfall.
Various risk management strategies are being tried regarding GMDBs: (a) Delta Hedging with Equity and Bond Futures—reasonably effective over short term and stable markets, but substantial exposure remains to market gaps and hedge accounting is very difficult to achieve; (b) Delta Hedging and Equity Vanilla Options—effective over intermediate horizon and stable markets, but long term effectiveness is not well understood and hedge accounting is very difficult to achieve; (c) Delta Hedging and Exotic Equity Options—effective over intermediate horizon and stable markets; but long term effectiveness is not well understood and hedge accounting is very difficult to achieve.